UNITED STATES OF AMERICA
Before the
SECURITIES AND EXCHANGE COMMISSION
INVESTMENT ADVISERS ACT OF 1940
Release No. 1571 / July 16, 1996
ADMINISTRATIVE PROCEEDING
File No. 3-9043
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| ORDER INSTITUTING PUBLIC
In the Matter of | ADMINISTRATIVE AND CEASE-
| AND-DESIST PROCEEDINGS
| PURSUANT TO SECTIONS 203(e),
McKenzie Walker Investment | 203(f) AND 203(k) OF THE
Management, Inc. and | INVESTMENT ADVISERS ACT OF
Richard C. McKenzie, Jr. | 1940 AND FINDINGS AND ORDER
| OF THE COMMISSION
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I.
The Securities and Exchange Commission ("Commission") deems
it appropriate and in the public interest to institute public
administrative and cease and desist proceedings against McKenzie
Walker Investment Management, Inc. ("McKenzie Walker") pursuant
to Sections 203(e) and 203(k) of the Investment Advisers Act of
1940 ("Advisers Act") and against Richard C. McKenzie, Jr.
("Richard McKenzie") (collectively, "Respondents") pursuant to
Sections 203(f) and 203(k) of the Advisers Act.
In anticipation of the institution of these proceedings,
McKenzie Walker and Richard McKenzie have submitted an Offer of
Settlement ("Offer") which the Commission has determined to
accept. Solely for the purpose of these proceedings and any
other proceedings brought by or on behalf of the Commission or in
which the Commission is a party, without admitting or denying the
findings contained herein, except that Respondents admit the
jurisdiction of the Commission over them and over the subject
matter of these proceedings, McKenzie Walker and Richard McKenzie
consent to the issuance of this Order Instituting Public
Administrative and Cease and Desist Proceedings Pursuant to
Sections 203(e), 203(f) and 203(k) of the Investment Advisers Act
of 1940 and Findings and Order of the Commission ("Order").
Accordingly, IT IS ORDERED that administrative and cease and
desist proceedings pursuant to Sections 203(e), 203(f) and 203(k)
of the Advisers Act be, and hereby are, instituted.
II.
On the basis of this Order and the Respondents' Offer, the
Commission makes the following findings.
A. FACTS
1. Respondents
McKenzie Walker is, and was at all relevant times, a
Delaware corporation, whose principal place of business is in
Greenbrae, California. McKenzie Walker has been registered with
the Commission as an investment adviser since 1982.
Richard McKenzie, age 54, is a resident of Kentfield,
California. He founded McKenzie Walker with a partner in 1982.
Since 1990, and during the period of the conduct discussed below,
Richard McKenzie has been associated with McKenzie Walker as its
sole director, officer, shareholder and primary portfolio
manager.
2. McKenzie Walker's Investment Advisory Business
During the relevant period,1/ McKenzie Walker had
approximately 33 accounts with over $300 million in assets under
its management. Richard McKenzie managed the assets of 29
accounts and supervised an assistant who managed the remaining
four.
McKenzie Walker charged its clients one of two kinds of
fees for its advisory services. Under a performance-based fee
arrangement, McKenzie Walker charged a fee of 20% of the gain in
the account. Under an asset-based fee arrangement, McKenzie
Walker charged from 1% to 3% of the assets under management.
During the relevant period, approximately 7 of McKenzie Walker's
clients selected an asset-based fee arrangement and approximately
26 clients selected a performance-based fee arrangement. Richard
McKenzie managed accounts for a former business partner of
McKenzie Walker, one of McKenzie Walker's lawyers, and a former
colleague from the mutual fund complex at which Richard McKenzie
had been a portfolio manager, all of whom paid a fee based on the
accounts' performance.
Richard McKenzie, as McKenzie Walker's primary portfolio
manager, ultimately had discretionary trading authority over all
client accounts. In allocating purchases and sales of equity
securities, Richard McKenzie generally used profitable equity
1/ All findings in this Order relate to the period of August
1,
1992 through September 30, 1993, unless a different time
period is specified.
trades to "smooth" or "boost" an account's performance. A
profitable trade was one which resulted in a gain during the time
interval between the execution of a trade before the end of a
trading day and its allocation to an account at the end of the
same trading day.
McKenzie Walker also used hot initial public offerings
("IPOs") to boost the performance of certain accounts.2/
McKenzie Walker frequently knew from the broker-dealers with whom
it did business if investors had expressed interest in an IPO,
and, if so, whether the IPO's share price was expected to rise in
the immediate aftermarket. Upon allocation of a hot IPO, Richard
McKenzie estimated the amount of profit a designated account
could earn from buying and selling the IPO's shares in the
aftermarket. In most cases, McKenzie Walker ordered shares of a
hot IPO sold into the aftermarket within seven days.
3. McKenzie Walker's Allocation Practices
McKenzie Walker's portfolio managers allocated trades by
considering each client's needs and investment objectives,
including factors such as the account's cash position, industry
weights and the particular securities already in each client's
portfolio, and applying the portfolio managers' subjective
judgment thereto. Other than the portfolio managers' discretion
and application of the factors just mentioned, McKenzie Walker
did not prescribe for its portfolio managers any objective
procedures or formula for allocating trades among clients or
maintain any internal control mechanism to monitor whether
portfolio managers allocated trades fairly. McKenzie Walker's
compliance officer was not required to review a portfolio
manager's allocation practices and no one undertook to assess
whether all accounts received an equitable allocation of trades
consistent with their investment objectives.
McKenzie Walker's allocation practices resulted in a
disparate allocation of profitable equity trades which
significantly favored McKenzie Walker's 26 performance-based fee
accounts and disfavored its 7 asset-based fee accounts.
Similarly, Richard McKenzie's allocation practices as well as the
practices of another portfolio manager whose trades Richard
McKenzie reviewed and approved, resulted in the allocation of hot
IPOs which significantly favored McKenzie Walker's performance-
based fee accounts and disfavored its asset-based fee accounts.
McKenzie Walker did not disclose these allocation practices to
its clients.
2/ "Hot IPOs" as used in this Order means securities of a
public offering that trade at a premium in the secondary
market whenever such trading commences.
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As a result of its allocation practices, McKenzie Walker's
fees were increased by at least $224,683.00.
a. McKenzie Walker Failed to Disclose Its Practice of
Favoring Its Performance-Based Fee Clients In the
Allocation of Equity Trades
Richard McKenzie allocated specific equity trades to
accounts after McKenzie Walker's trader had executed his order to
buy or sell the securities. As a general practice, he used the
time interval between the order execution (which occurred
throughout the trading day) and the allocation of the equity
trade (at the end of the same trading day) to assess whether the
position had gained or lost in relation to the intervening
movement in the market. After observing the market's movement,
he relegated the unfavorable purchases and sales to asset-based
fee accounts at a far greater rate than to the performance-based
fee accounts and, conversely, allocated the profitable trades to
performance-based fee accounts at a far greater rate than to the
asset-based fee accounts. With respect to securities actually
traded in both types of accounts, Richard McKenzie allocated to
the performance-based fee accounts approximately 3.7 profitable
trades for every 3 unprofitable trades and allocated to the
asset-based fee accounts approximately 2 profitable trades for
every 3 unprofitable trades. In sum, the performance-based fee
accounts received favorable trades at approximately twice the
rate of the asset-based fee accounts.
Moreover, among the performance-based fee accounts, Richard
McKenzie favored certain clients even more than other
performance-based fee accounts. A former business partner of
McKenzie Walker, one of McKenzie Walker's lawyers, and a former
colleague from the mutual fund complex at which Richard McKenzie
had been a portfolio manager, received 5.4 to 7.8 profitable
trades for every 3 unprofitable trades. McKenzie Walker did not
disclose to its clients either its practice of favoring the
performance-based fee accounts generally or its practice of
favoring certain performance-based clients specifically in the
allocation of equity trades.
b. McKenzie Walker Failed to Disclose Its Practice of
Favoring Its Performance-Based Fee Clients in the
Allocation of Hot IPOs
Without disclosure to its clients eligible to trade in
IPOs, or to any other clients, McKenzie Walker also allocated a
substantially disproportionate share of hot IPOs to performance-
based fee clients. As with ordinary equity trades, McKenzie
Walker's portfolio managers allocated IPOs after their purchase
orders for the IPO had been executed and after they had an
opportunity to observe the IPO's price rise (or fall) in the
aftermarket. Of the $910,000 in gross trading profits that
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McKenzie Walker earned for its clients between January 1, 1992
and December 31, 1992 by selling IPOs within seven days, the 7
asset-based fee accounts received only $18,240 or 2%. The asset-
based fee accounts also received $24,375 in trading losses from
poor performing IPOs, for a net loss to that group of $6,135. In
contrast, the 26 performance-based fee accounts received the
remaining $892,095, or 98%, of the gross IPO trading profits and
no trading losses.
B. LEGAL ANALYSIS
The Advisers Act imposes on investment advisers an
affirmative duty to act in good faith for the benefit of their
clients and to disclose fully and fairly all material facts. SEC
v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963).
See also In the Matter of Chancellor Capital Management, Inc.,
Advisers Act Release No. 1447 (October 18, 1994) citing
Transamerica Mortg. Advisors, Inc. v. Lewis, 444 U.S. 11, 17
(1979). A fact is material if there is a substantial likelihood
that a reasonable investor would consider it important in making
an investment decision. Basic, Inc. v. Levinson, 485 U.S. 224,
231-32 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S.
438, 449 (1976).
Section 206(2) of the Advisers Act prohibits an investment
adviser from engaging "in any transaction, practice or course of
business which operates as a fraud or deceit upon any client or
prospective client." A violation of Section 206(2) does not
require a showing of scienter but may rest on a finding of
negligence. SEC v. Steadman, 967 F.2d 636, 643, n.5 (D.C. Cir.
1992), citing Capital Gains Research Bureau, 375 U.S. at 191-
92.3/
McKenzie Walker willfully violated Section 206(2) of the
Advisers Act by failing to disclose to its clients, current or
prospective, that it engaged in a practice of generally favoring
its performance-based fee clients in the allocation of equity
trades and hot IPOs, and specifically favoring certain of its
performance-based fee clients over such clients. The omitted
facts were material. A reasonable investor, who was
contemplating entering into or continuing an advisory arrangement
with McKenzie Walker, would consider it important to know of
those allocation practices. See also In the Matter of Thomas H.
Richards, Investment Advisers Release No. 1495 (June 6, 1995);
In the Matter of Account Management Corporation, Investment
3/ "Willfully" as used in this Order means intentionally
committing the act which constitutes the violation. There
is no requirement that the actor also be aware that he is
violating the Act. See Tager v. SEC, 344 F.2d 5 (2d Cir.
1965).
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Advisers Release No. 1529 (September 29, 1995).
Richard McKenzie rendered "substantial assistance" to
McKenzie Walker's violations of Section 206(2) and thereby
willfully aided and abetted, and caused, McKenzie Walker's
violations of Section 206(2). As the director, president and
sole shareholder of McKenzie Walker, Richard McKenzie was
responsible for McKenzie Walker's disclosure of material
information to clients. As McKenzie Walker's principal portfolio
manager, he implemented and sanctioned its allocation practice
which resulted in favoritism of performance-based fee clients
when allocating equity trades and hot IPOs. Richard McKenzie was
also generally aware of an investment adviser's duty to act in
good faith for the benefit of all clients.
Based on the foregoing, the Commission finds that:
1. McKenzie Walker willfully violated Section 206(2) of
the Advisers Act;
2. Richard McKenzie willfully aided and abetted and caused
McKenzie Walker's violations of Section 206(2) of the Advisers
Act.
III.
On the basis of the foregoing, it is appropriate and in the
public interest to impose the sanctions which are set forth in
the Offer submitted by McKenzie Walker and Richard McKenzie.
Accordingly, IT IS ORDERED, that:
A. McKenzie Walker Investment Management Inc. is censured;
B. Richard C. McKenzie, Jr. is censured;
C. Pursuant to Section 203(k) of the Advisers Act,
McKenzie Walker shall cease and desist from committing
or causing any violations of, and any future violations
of, Section 206(2) of the Advisers Act;
D. Pursuant to Section 203(k) of the Advisers Act, Richard
McKenzie shall cease and desist from committing or
causing any violation of, and any future violation of,
Section 206(2) of the Advisers Act;
E. McKenzie Walker shall, within thirty (30) days of the
entry of the Order, pay disgorgement in the amount of
$224,683 plus $35,974 in prejudgment interest. Such
payment shall be: (A) made by United States postal
money order, certified check, bank cashier's check or
bank money order; (B) made payable to the Securities
==========================================START OF PAGE 6======
and Exchange Commission; (C) mailed by certified mail
to the Comptroller, Securities and Exchange Commission,
450 Fifth Street, N.W., Washington, D.C. 20549; and (D)
submitted under cover letter which identifies McKenzie
Walker as a Respondent in these proceedings, with a
copy of said cover letter and money order or check sent
to David B. Bayless, District Administrator, Securities
and Exchange Commission, 44 Montgomery Street, Suite
1100, San Francisco, CA 94104;
F. McKenzie Walker shall, within thirty (30) days of the
entry of the Order, pay a civil money penalty in the
amount of $100,000. Such payment shall be: (A) made by
United States postal money order, certified check, bank
cashier's check or bank money order; (B) made payable
to the Securities and Exchange Commission; (C) mailed
by certified mail to the Comptroller, Securities and
Exchange Commission, 450 Fifth Street, N.W.,
Washington, D.C. 20549; and (D) submitted under cover
letter which identifies McKenzie Walker as a Respondent
in these proceedings, with a copy of said cover letter
and money order or check sent to David B. Bayless,
District Administrator, Securities and Exchange
Commission, 44 Montgomery Street, Suite 1100, San
Francisco, CA 94104.
By the Commission.
Jonathan G. Katz
Secretary
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